One Year Later...How it all started...How Wall Street Got Burnt...How it affects you
Ayodeji Jeremiah
“They say that when America sneezes, Europe catches cold, Asia develops pneumonia and Africa’s tuberculosis gets worse. This is what we are beginning to see.” - Raila Odinga, Prime Minister Kenya
First, it was French bank BNP Paribas that took a hit but not many people took notice. Then a slew of other financial institutions such as German regional bank Sachsen Landesbank, German corporate lender IKB, US mortgage lender IndyMac (the second biggest bank in US history to fail) and British mortgage lender Northern Rock followed. The big bang that made many to take notice worldwide, took place however on March 17 2008 when Bear Stearns, Wall Street's fifth-largest bank was acquired by larger rival JP Morgan Chase for $240m in a deal backed by $30bn of central bank loans. A year earlier, Bear Stearns had been worth £18bn. (Bear Stearns was founded originally in 1923 by Joseph Bear, Robert Stearns and Harold Mayer as an equity-trading house in New York. It became a public company in 1985 when it formed a holding company called Bear Stearns Companies, Inc. and reorganised from a brokerage house into a full-service investment firm.) It may not have the storied history of a Merrill Lynch or a Lehman Brothers but its collapse will be the beginning of a cataclysmic fall for major Wall Street banks.
A little over two years ago, few people had heard of the term credit crunch but the phrase has now entered the layman’s lexicon. Defined as "a severe shortage of money or credit", the start of the phenomenon has been pinpointed as 9 August 2007 with the bad news from BNP Paribas that they will not be able to take money out of two of their funds because they cannot value the assets in them, owing to a "complete evaporation of liquidity" in the market. This immediately signalled that banks had become unwilling to do business with each other, which triggered a sharp price in the cost of credit and made the financial world realise how bad the situation was.
Initially called the US financial crisis (due to its origins from the United States), the global financial crisis started much earlier in 2006. Between 2004 and 2006, US interest rates rose from 1% to 5.35%; in 2006 however, the US housing market began to suffer, this was subsequently referred to as the Sub-Prime Mortgage Crisis in which US banks gave high risk loans to people with poor credit histories. Falling house prices and rising interest rates led to high numbers of people who could not repay their mortgages. These and other loans, bonds or assets were bundled into portfolios (Collateralised Debt Obligations (CDOs)) and sold on to investors globally. Investors began to suffer losses, making them reluctant to take on more CDOs. The credit markets freezed as banks were reluctant to lend to each other, not knowing how many bad loans could be on their rivals' books.
Although the US housing collapse is often blamed for causing the US financial crisis and even the global economic crisis, the global financial system was already vulnerable because of the abundance of complex and highly leveraged financial contracts and operations. According to Matthew Phillips (Newsweek October 13 2008), such complex financial instruments such as CDOs had their origins way back to 1994 and due to little or no regulations took on a world of their own. According to his story, which has become the stuff of Wall Street legend; during a 1994 ‘offsite weekend’ by a group of JP Morgan bankers, (Offsite weekends are rituals of the high-finance world in which teams of bankers gather someplace sunny to blow off steam and celebrate their successes as Masters of the Universe, think yacht parties, bikini models, $1,000 bottles of Cristal), a group of them were trying to get their heads around a question as old as banking itself: how do you mitigate your risk when you loan money to someone?
The young bankers (most were in the 20s and fresh out of MIT, Stanford, Princeton or Harvard) created a device that would protect their bank if the loans defaulted and free up their capital. What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour and in exchange would receive regular payments from the bank, similar to insurance premiums. The bank would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap" and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices. While the concept had been floating around the markets for a couple of years, JP Morgan was the first bank to make a big bet on credit default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and science graduates from Ivy league schools to create a market for the complex instruments. Within a few years, the credit default swap (CDS) became the hottest financial instrument, the safest way to parse out risk while maintaining a steady return. What the JP Morgan bankers did not realise was that they were creating a monster. That Wall Street is in ruins is due in no small part to the monster they unleashed 15 years ago.
So much of what's gone wrong with the financial system in the past two years can be traced back to credit default swaps, which ballooned into a $62 trillion market, nearly four times the value of all stocks traded on the New York Stock Exchange. There's a reason Warren Buffett called these instruments "financial weapons of mass destruction." Since credit default swaps are privately negotiated contracts between two parties and aren't regulated by the government, there's no central reporting mechanism to determine their value. That has clouded up the markets with billions of dollars worth of opaque "dark matter," as some economists like to say. They proliferated around the world waiting to blow up the balance sheets of countless other financial institutions, which they evetually did. Credit default swaps were initially used to get banks to get their credit risk off their books and into non-financial institutions like insurance companies and pension funds. Before long however, everyone was using CDS to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions and credit default swaps proved just the tool. When the US housing boom started, CDS again proved a useful tool to protect investors against default of mortgage backed securities.
After the fall of Bear Stearns; Fannie Mae and Freddie Mac, AIG, Washington Mutual, Lehman Brothers and Merrill Lynch all followed. The US government reacted in varying degrees to the fall of each company, allowing some to die while rescuing others. September 2008 seems to have been the month of epiphany for the US government and the institutions involved. On September 7 2008, financial authorities stepped in to assist America's two largest lenders, Fannie Mae and Freddie Mac. As owners or guarantors of $5 trillion worth of home loans, they were crucial to the US housing market and US authorities agreed they could not be allowed to fail; the US government rescued both in one of the largest bailouts in US history. On September 10, Lehman Brothers announced a loss of $3 billion dollars over a three month period. On September 15, days after frantically searching for a buyer, the company filed for Chapter 11 bankruptcy protection. In a dramatic twist of events, Merrill Lynch agreed to be taken over by Bank of America for $50 billion. The following day, The US Federal Reserve announced an $85 billion rescue package for AIG, the country's biggest insurance company, to save it from bankruptcy. AIG got the loan in return for an 80% public stake in the firm. When AIG’s stock fell, the Dow Jones Average also fell triggering a panic on the New York Stock Exchange. On September 25, Washington Mutual, valued at $307 billion was closed down by regulators and sold to JP Morgan Chase.
The storied history of Merrill Lynch and Lehman Brothers still leave many in disbelief about their downfall. Less than two years ago, working with any of the big five (Bear Stearns, Lehman Brothers, Goldman Sachs, Merrill Lynch and Morgan Stanley) was about the most prestigious thing you could do. Rock legends earned less. Heart surgeons got less respect. Porches had less power. Screen stars had fewer girlfriends. You were on top of the world. You earned more than anyone else. You knew more. You were better educated, the top of the class from the top schools. You understood what a CDO was and a swap and a derivative. Naturally, other people, ordinary people looked up to you. They gave you good tables at restaurants. They parked your car without scratching it against a fire hydrant. Women wanted to meet you and men asked your advice on economics, politics, fashion, art etc. You were a member of that special club, the secret order and the high priests of the modern world. Today, only two of those five are still standing.
Lehman Brothers started in 1844 when Henry Lehman emigrated from Germany to Montgomery, Alabama, US and started a small trading shop selling groceries, dry goods and utensils to local cotton farmers. The company evolved from a general merchandising business to a commodities broker and later an investment bank. In 1984, Lehman Brothers was acquired by American Express and merged with its retail brokerage Shearson to form Shearson Lehman Brothers. American Express began to divest its financial services by business lines in 1992 and eventually, in 1993, the firm was spun off and once again became known solely as Lehman Brothers. In 2000, Lehman celebrated its 150th anniversary. The company's World Trade Centre offices were destroyed by the 2001 terrorist attacks and eventually it moved into its new global headquarters in midtown Manhattan in 2002. In 2008, it ceased to exist.
Charles Merrill and Edmund Lynch met in 1907 while the former was working for a textile company and became room mates. In 1914, Merrill opened his company and invited Lynch to join him four months later. The company, which started as Charles E. Merrill and Co changed its name to Merrill, Lynch and Company. Edmund Lynch died in 1938 after which the company dropped the comma from its name out of respect for the deceased partner. The company went public in 1971 and was listed on the New York Stock Exchange and by 1999 was the world’s largest underwriter of stocks and bonds.
The collapse of these major US financial institutions in September 2008 acted as a wake up call for the global community. The global economic crisis was said to have entered its acute phase. Investors began fleeing with panic as headlines proclaimed the global onset of "Financial Crisis 2008" and the global economy was on the brink of collapse. Many governments including the US, UK and other European governments had to execute painfully costly bail out plans to keep their respective economies from going down with the ship, or at least to keep them afloat in anticipation of market recovery. The US government announced a $250 billion plan in October 2008, to directly buy shares in leading US banks. When financial markets stabilise and recover, the banks are expected to buy the stock back from the government (Goldman Sachs has done so already.) Nine banks were initially expected to participate in the plan including some of the largest institutions in the US including Citigroup, Wells Fargo, JP Morgan, Chase & Co, Bank of America and Morgan Stanley. Wachovia, the fourth largest US bank was bought by Citigroup in a rescue deal backed by US authorities, which saw Citigroup absorbing $42 billion of Wachovia’s losses. A $20 billion rescue package was announced by the US government for Citigroup after its share price plunge by more than 60% in one week.
Authorities in the Netherlands, Belgium and Luxembourg poured in $16.1 billion into European insurance and banking giant Fortis amidst concerns about its falling share price and mounting debts. Fortis was seen as too big a European bank to be allowed to go under. The British government nationalised mortgage lender, Bradford & Bingley and injected over $50 billion into Royal Bank of Scotland, Lloyds TSB and HBOS; the Icelandic government took control of the country’s second and third largest banks, Landsbanki and Glitnir respectively; the Irish government announced that it will guarantee all the deposits in the country’s main banks for two years, while the Belgian, French and Luxembourg governments bailed out Dexia with the injection of $9 billion in fresh funding. Germany announced a $68 billion plan to save Hypo Real Estate, one of the country’s biggest banks. The Dutch government injected $13.4 billion into banking and insurance company, ING. South Korea announced a $130 billion package to stabilise its markets by offering a guarantee on its banks’ foreign debts, the Swedish government did same with a $205 billion guarantee, China set out a two year $586 billion economic stimulus package that will help boost the economy through investment in infrastructure and cutting of corporate taxes, the European Commission unveiled an economic recovery plan worth 200 billion euros and the US Federal Reserve injected $800 billion into the economy in a further effort to stabilise the financial system and encourage lending. Major central banks around the world including the US Federal Reserve Bank, the European Central Bank, bank of England and the central banks of Canada, Sweden, India and Switzerland all make emergency interest rate cuts. The International Monetary Fund announced loans of $16.4 billion for Ukraine, $7.6 billion for Pakistan and $2.1 billion for Iceland, the loan to Iceland will be the first to a Western European country since 1976.
Perhaps ironically, because of Africa’s generally weak integration with the rest of the global economic system, as reported by Reuters, it is believed many African countries will not be affected from the crisis, at least not initially (this has been so thus far). The wealthier ones who do have some exposure to the rest of the world, however, may face some problems. Foreign Direct Investment (FDI) and foreign aid will definitely diminish. Trade incentives for African countries will evaporate; demand for products from emerging countries such as African ones will reduce even as there may be an increased pressure for debt repayments. There will consequently be less financing for development activities. This will affect social services such as health, water supply and education, which are already lacking in funds. Workers’ remittances, which is as high as FDI (African Diasporas sent back some $15 billion last year) has declined as the crisis affects European and South African labour markets. Overall economic growth in Africa as projected by IMF is expected to decline from an average of 7% to less than 6% in 2009.
Many people are now calling for the restructuring of the world’s financial and banking system. According to Columbia University Economics professor and 2001 Nobel Prize Economics winner, Joseph Stiglitz, “America’s financial system failed in its two crucial responsibilities: managing risk and allocating capital. The industry as a whole has not been doing what it should be doing and it must now face change in its regulatory structures. Regrettably, many of the worst elements of the US financial system were exported to the rest of the world.” He argues that the failures in the financial markets have come about because of a poorly designed incentive structure, inadequate competition and inadequate transparency. He makes a case for better regulation to help reign in the financial markets and bring back trust in the system.
During periods of boom, no-one would want to hear of caution and even thoughts of the kind of regulation that many are now advocating. To suggest anything would be anti-capitalism or socialism or some other label that could effectively shut up even the most prominent of economists raising concerns. Of course, the irony that those same people and institutions would now agree that those “anti-capitalist” regulations are required is of course barely noted. Such options now being considered are not anti-capitalist or whatever. This reveals that there are various forms of capitalism, the most extreme of which leads to the biggest bubbles and the biggest busts.
Harvard professor of economics, Stephen Marglin argues that in recent decades, the policy spectrum and thinking on economics has narrowed thereby limiting ideas and options available. Some have been writing for many years that while the current economic ideology is flawed, it only needs minor tweaking to correct it and make it work for everyone; a more compassionate capitalism, or social capitalism as advocated by Bill Gates but capitalism nonetheless. Others argue that capitalism is so flawed it needs complete doing away with. Others may yet argue that the bailouts by large government will distort the markets even more (encouraging bad practices by the big institutions) and rather than more regulation, an even freer form of capitalism is needed. What seems clear is that at least for a while, debate will increase in the mainstream even as many (individuals, organisations and countries) continue to writhe under the weight of the crisis.
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